Monetary Policy

IV. MONETARY POLICY

Readings

Mankiw, Macroeconomics, ch. 18, sec. 18.1
Mankiw, Macroeconomics, ch. 12 and 13 (optional)

Notes on the Effects of Money on Interest Rates

"Schools Brief: Paradigm Lost", The Economist, November 3, 1990
"Schools Brief: A Cruise Around the Phillips Curve", The Economist, February 19, 1994
"Schools Brief: Rules v. Discretion", The Economist, March 2, 1991
"Dow Industrials Jump 380.53 to 8020.78: Point Gain Sets Record; Joy Is Muted", The Wall Street Journal, September 9, 1998
"Fed Cuts Short-Term Rates by 0.25 Point", The Wall Street Journal, September 30, 1998
Thornton, "Does The Fed Influence Interest Rates?", Federal Reserve Bank of St. Louis Monetary Trends, January 1995
Barro, "What the Fed Can't Do", The Wall Street Journal, August 19, 1994
Barro, "Keep Political Hands Off the Fed", The Wall Street Journal, August 26, 1992
"Admiring Those Shapely Curves", The Economist, April 4, 1998

This module continues the study of monetary economics, giving particular attention to the central bank’s conduct of monetary policy and the effects of monetary policy on the real economy.

The module begins with an examination of the Federal Reserve system, financial intermediation, and the money supply process. The primary analytical material is a set of notes and a portion of chapter 18 of Mankiw.

The module then examines the short-run effects of monetary policy on the economy. An important feature of the monetary sector studied up to this point is that money is neutral. The real sector of the economy affects the monetary sector, but not vice versa. This feature of the economy is called the classical dichotomy. The classical dichotomy is a good characterization of the long-run behavior of the economy.

Most economists believe that the classical dichotomy between the monetary and real sectors holds only in the long run but breaks down in the short run. We now break the classical dichotomy and study how money affects real variables in the short run, beginning with the simplest case of a closed economy. The main analytical readings for this class are three "Schools Briefs" from The Economist. The central result is that an unexpected increase in the money supply (or in its growth rate) results in a temporary increase in real output and a temporary decline in unemployment. In the long run, however, a change in the money supply is fully perceived and ceases to have any real effects on the economy.

Economists have not yet come up with a single, fully satisfactory model that reconciles the short-run non-neutrality of money with long-run neutrality. The "Schools Briefs" articles describe several alternative theories. Chapter 11 of Mankiw, which is optional, describes four alternative models in more detail. The truth may consist of some combination of these theories and possibly of others that we have not yet thought of.

Some of the theories described in the "Schools Briefs" imply that business cycles are a natural, efficient, and optimal result of the workings of a market economy, and that government should not try to eliminate cycles or reduce their magnitude. Other models imply that business cycles lead to inefficiently low output and employment during recessions. If government were wise and skillful enough, it could and presumably should pursue countercyclical macroeconomic policies to reduce the cost of recessions. There is serious dispute about whether government is skillful enough to pursue these policies effectively, however. This is the question of rules versus discretion. Chapter 12 of Mankiw, which is also optional, deals with this debate in more detail.